Tuesday's Top Upgrades (and Downgrades)

Tuesday's Top Upgrades (and Downgrades)

This series, brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense, and which ones investors should act on. Today, our headlines feature a downgrade for homebuilder NVR , but an upgrade for Masco -- and for AeroVironment , an increase in price target. Let's dive right in.

Are homebuilders in trouble?
On the front page of today's Wall Street Journal, banker Wells Fargo is quoted warning investors at a banking conference of an impending 28% drop in mortgage originations in Q3. A few lines down, JP Morgan Chase chimes in with its own worries that it's likely to lose money on mortgage originations in this year's second half.

And continuing the theme, this morning we learned from StreetInsider.com that Swiss megabanker Credit Suisse has just downgraded homebuilder NVR... to underperform. Credit Suisse hates NVR more than it hates either Beazer or D.R. Horton -- two other homebuilders it downgraded today, but only to neutral. It likes NVR a whole lot less than rival M.D.C. Holdings, the only homebuilder the banker decided to upgrade.

But why would you want to take Credit Suisse's advice about these stocks?

Let me count the ways. Comparing the two companies at the opposite ends of Credit Suisse's ratings scale, NVR costs more than 22 times earnings. MDC costs only five times earnings. Valued on their assets, NVR costs more than 3.1 times book value; MDC -- less than 1.3. And of course, at the most basic, tangible level, MDC pays its shareholders a generous 3.6% dividend yield... while NVR pays zilch.

If ever an analyst was painting an argument for making a "paired trade," selling one stock short, and using the money to buy another, similar, but cheaper stock -- Credit Suisse appears to be making that case for us today.

Aside from homebuilders, are there other opportunities in housing?
Despite rumors of an impending decline in mortgage originations, all's not entirely bleak in the homebuilding sector, as Credit Suisse's upgrade of MDC makes clear. And indeed, other analysts think they see additional opportunities to invest in a housing market that may not be done running just yet. (As we'll see in a moment, they're wrong... but still worth considering, just to see what the analysts are saying).

Take cabinetmaker Masco for instance. This morning, analysts at Oppenheimer announced an upgrade of Masco shares to outperform, predicting that housing market "tailwinds" will continue, and will help lift the stock to $25 within a year. According to Oppy, "[Channel] checks indicate [that the] positive momentum MAS cited in July ... persisted through the summer, setting [the stock] up for a strong 3Q13." Indeed, even assuming Masco fails to achieve its targeted 30% gross margins in 2014 and 2015 (the company's grossing about 26% right now), Oppenheimer still likes the stock's chances, as sees the potential for a 20% gain in share price.

But is Oppenheimer right? Can stronger margins, and stronger sales, make Masco a buy?

I wish I could say yes, but it's hard to see how the analyst could be right. Priced at 150 times earnings today, Masco's stock looks far too overvalued to ever have any chance of outperforming the market. Sure, over the past 12 months, Masco generated some $218 million in positive free cash flow from its business, which is more than four timesas much cash profit as the $52 million in "net income" the company was allowed to report under GAAP.

But even so, this leaves the stock trading for 34 times earnings. With most analysts saying that, even with strong Q3 results, Masco can only grow earnings at about 10% consistently over the next five years (according to S&P Capital IQ), 34 times free cash flow still looks like too high a price to pay, to me.

A wild card
Switching gears, from the field of building things to blowing things up, we turn to unmanned aerial vehicle maker AeroVironment -- a company that's had a pretty astounding run of good luck lately, racking up Pentagon defense contracts left and right, as the U.S. Army stocks up on the company's new "Switchblade" flying bomb.

This morning, and for the second time in two weeks, analysts at The Benchmark Company reiterated their support for AeroVironment stock, raising their price target from $24 to $26 a share. Encouraged by a recent earnings report in which AV hit analyst targets and reaffirmed its guidance for this year, Benchmark explained in August that it thinks the company's Switchblade product, for which "theater commanders [are demanding] more" units, will help to drive results going forward.

The Pentagon's been quick to respond to its commanders' on-the-ground requests, issuing a series of follow-on orders for more Switchblades. At last count, these orders now tally $52.5 million -- 23% of the company's annual revenues -- for just the past six weeks. If orders keep coming in at the rate they have been, therefore, it's entirely possible that AV will blow right past analysts' consensus expectations for 14% long-term earnings growth.

So... does this make AeroVironment a buy?

It's hard to say. On the one hand, AV looks likely to outperform expectations on Wall Street -- and that could well give the stock a lift. On the other hand, though, such a lift may prove short-lived. With a stock priced at 110 times trailing earnings, and more than 34 times trailing free cash flow, it's arguable that a lot of AeroVironment's future Switchblade success is already being taken as a given by investors, and priced into the stock.

Long story short... much as I applaud AeroVironment's business success, I'd still be leery of going long on the stock.

Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends AeroVironment and Wells Fargo. The Motley Fool owns shares of AeroVironment, JPMorgan Chase & Co., and Wells Fargo. The Motley Fool has a disclosure policy.


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